The Dangers Of Deflation

When most of us think of inflation, we think of rising prices that strain budgets and take away our buying power. During the late 1970s and early 1980s, inflation skyrocketed as high as 14.8% in the U.S. and interest rates climbed to similar levels. Few living Americans know what it's like to face the opposite phenomenon - deflation.

Since too much inflation is generally regarded as a bad thing, wouldn't it follow that deflation might be good thing? Not necessarily, since much depends on the cause and circumstances of the deflationary cycle and how long it lasts. (Deflation has continued to pop up throughout economic history - but is that such a bad thing? Learn more in The Upside Of Deflation.)

What Is It?Deflation is a general decline in prices as a function of supply and demand for products, and the money used to buy them. Deflation can be caused by a decrease in the demand for products, an increase in the supply of products, excess production capacity, increase in the demand for money, or a decrease in the supply of money or availability of credit.

Decreased demand for products can manifest itself in the form of less personal spending, less investment spending and less government spending. While deflation is often associated with an economic recession or depression, it can occur during periods of relative prosperity if the right conditions are present.

Practical ApplicationIf prices are dropping because a product can be produced more efficiently and cheaply in greater quantity, that's viewed as a good thing. An example of this is consumer electronics which are far better and more sophisticated than ever. Yet prices have consistently dropped as the technology improved and spurred more demand. (Learn more in our Economics Basics Tutorial.)

The effect on prices by fluctuations in the demand for money is usually a function of interest rates. As the demand for money increases during a period of inflation, interest rates rise to compensate for the higher demand and to keep prices from rising further. Conversely, deflation will result in lower interest rates as the demand for money drops. In that case, the goal is to spur buyer demand to stimulate the economy.

The Great DepressionSevere economic contraction during the Great Depression resulted in deflation averaging -10.2% in 1932. As the stock market began to crater in late 1929, the supply of money declined along with it as liquidity was drained from the marketplace.

Once the downward spiral had begun, it fed on itself. As people lost their jobs, this reduced the demand for goods, causing further job losses. The decline in prices wasn't enough to spur demand because rising unemployment undercut consumer purchasing power to a far greater degree. The snowball effect didn't stop there, as banks began to fold as loan defaults rose dramatically.

As banks stopped lending money and credit dried up, the money supply contracted and demand tanked. Although the demand for money remained high, no one could afford it because the supply had shrunk. Once this vicious cycle took hold, it lasted a decade until the beginning of World War II.

Possible EffectsThere are many reasons to be concerned about a prolonged deflationary period, even without an event as devastating as the Great Depression:

1. Demand for goods decreases since consumers delay purchases, expecting lower prices in the future. This compounds itself as prices drop further in response to decreasing demand.

2. Consumers expect to earn less, and will protect assets rather than spend them. Since 70% of the U.S. economy is consumer-driven, this would have a negative effect on GDP.

3. Bank lending drops since borrowing money makes less sense in regards to the real cost. This is because the loan would be paid back with money that is worth more than it is now.

4. Deflation ensures that borrowers which loot to purchase assets lose since an asset becomes worth less in the future than when it was bought.

5. The more indebted you are, the worse your condition since your salary will likely decline while your loan payments remain the same.

6. During inflation, there is no upper limit on interest rates to control the inflation. During deflation, the lower limit is zero. Lenders won't lend for zero percent interest. At rates above zero, lenders make money but borrowers lose and won't borrow as much.

7. Corporate profits usually drop during a deflationary period, which could cause a corresponding decrease in stock prices. This has a ripple effect to consumers who rely on stock appreciation and dividends to supplement their incomes.

8. Unemployment rises and wages decline as demand drops and companies struggle to make a profit. This has a compounding effect throughout the entire economy.

What to DoEver since the Great Depression, there has been a continuing debate on how best to combat recessions and deflation. Federal Reserve Chairman Ben Bernanke has adopted a policy of "quantitative easing," which essentially amounts to printing money to buy U. S. Treasuries. Following Keynesian economic theory, he is using the money supply to offset the economic contraction that resulted from the financial meltdown in 2008 and the bursting of the housing bubble. How this plays out remains to be seen since these policies are designed to cause inflation.

If the U.S. were to enter a sustained deflationary cycle, your best protection is to hold onto your job and have as little debt as possible. You don't want to be locked in to paying off a loan with money that is increasing in value every day. Save as much money as possible and defer discretionary purchases until prices are lower. Finally, consider selling assets that you don't need while they still have value.